The artificial intelligence (AI) lending company Upstart (UPST -0.16%) will report earnings results for the third quarter on Nov. 8 after what has been a difficult year. The stock has declined 84% this year.

As the Federal Reserve has aggressively hiked interest rates to try and get inflation under control, the company has been dealing with headwinds related to funding and potential credit issues down the line, which have significantly hampered growth. 

I also think it's very possible that Upstart continued to deal with these same issues in the third quarter of the year. Here's why.

Understanding the funding issues

Upstart is a fintech company that has developed its own proprietary underwriting algorithms that it believes can better assess credit quality than traditional methods, such as Fair Isaac's FICO scoring. The goal is also to use its underwriting to help borrowers lower on the credit spectrum gain access to traditional banking products while helping banks acquire new customers in an efficient manner.

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Image source: Getty Images.

Upstart is not a bank but rather a tech platform. Loans underwritten through the platform can be funded and retained by partner banks and credit unions, but the great majority of them are purchased by institutional investors.

The investors get capital to buy these loans through funding sources that charge interests that tracks the Federal Reserve's overnight benchmark-lending rate, the federal funds rate. With the Fed aggressively raising rates, institutional investors have faced higher costs of capital, which means they'll want higher-yielding loans to maintain their return thresholds. Upstart will be able to price loans higher, but there's a lag, and the Fed just keeps raising rates. Furthermore, rates have risen so quickly that many borrowers who once qualified for certain loans no longer can.

Furthermore, the Fed's rapid rate hikes have led many investors to worry about a severe recession, which could lead to higher loan defaults. Facing higher financing costs and the possibility of rising defaults, investors who fund and purchase Upstart loans are heading to the sidelines until conditions ease.

This makes growth difficult for Upstart because it has no one to buy its loans. Origination volume at Upstart fell from about $4.3 billion in the first quarter to roughly $3.1 billion in the second quarter, while revenue dropped from $310 million to $228 million. In the upcoming third quarter report, management has projected revenue of $170 million.

A warning sign

In a harbinger of what may be to come for Upstart, another online personal lending company called LendingClub (LC -2.81%) recently reported its third-quarter earnings results. The marketplace bank, which also sells the majority of its originations to investors, saw those loans drop from about $2.8 billion in the second quarter to roughly $2.39 billion in the third quarter.

LendingClub's Chief Executive Officer Scott Sanborn said the company had

more tempered loan volumes in marketplace revenue due to the rapidly changing rate environment, temporarily affecting loan investor demand. With the pace and scale of rate changes now more significant than prior expectations, the anticipated dynamic is more material.

Furthermore, LendingClub's forecast for the fourth quarter suggests continued pressure on loans sold to investors, who are seemingly prepared to sit things out until the Fed at least slows the pace of its rate hikes.

The kicker here for Upstart is that LendingClub banks a higher-quality customer overall, with the average FICO score of loans sold to investors around 718 at the end of the third quarter. Upstart primarily lends to near-prime customers, which only made up 10% to 12% of LendingClub's originations in the third quarter.

Potentially more trouble ahead

Given what we just heard on LendingClub's earnings call, and given that the Fed is now expected to raise the federal funds rate by 1.4 percentage points more than the market expected as recently as July, Upstart may have passed through a tough third quarter.

The company did provide a revised outlook in the previous quarter, so perhaps some of these difficult conditions are built into expectations. Upstart's management team did discuss trying to add committed capital , so it has a cushion for difficult environments like this, but this initiative could take some time to get up and running. The company may also hold some loans on its balance sheet, but the market hasn't always responded so well when the company does this. The company was designed to be a lending platform, not a bank.

Upstart's stock is way down this year, so it might be poised for a rebound if the Fed slows the pace of its rate hikes. But I just don't like investing in a company that is so vulnerable to rate hikes. Furthermore, I think management is going to have to do a better job of convincing investors that credit quality will hold up, especially considering where the economy might be headed.